Puerto Rico Causes Municipal Debt Tremors

Even since the Great Recession, municipal bonds have seen more trouble than is normal for this usually super-safe segment of the bond market. Several municipalities in California filed for bankruptcy (Stockton, Vallejo, San Bernardino), then there was Detroit, and now we have the Mother of them all, Puerto Rico.

I won’t bore you with the myriad interesting things about Puerto Rico’s bankruptcy, which is truly special in so many ways – except for this one ominous item. Judge Laura Taylor Swain, who is overseeing the bankruptcy of PR, ruled in mid May that revenue bonds backed by revenues could not, in fact, be paid by those revenues in bankruptcy situations until relief is granted from the automatic stay triggered by the filing itself. This was quite a surprise to participants.

Revenue bonds were heretofore assumed to have a direct lien on revenues that are generated by projects financed by the bonds, such that they stood above the fray in a bankruptcy filing. That meant that so long as the revenues were still being generated, the bonds would be paid. This is how Vallejo worked, for instance; Vallejo taught us that in fact GO bonds were vulnerable. GO bonds had always been thought to be of the highest quality, since their repayment could simply be secured by raising taxes. Instead, Vallejo’s revenue bonds turned into the champs, as revenues kept coming in, for electricity payments, sewer and water payments, and so forth. Meanwhile, everyone has found out that a bankrupt municipality can rarely raise taxes.

So now, derived from the PR proceedings, we have now been told in no uncertain terms that the court will decide the disposition of every iota of cash, not relevant bankruptcy code.

Of course this will go to appeal. However, it’s a very interesting development for municipal bond holders, who have just been reminded that if your bond issuer ends up in court, you might as well throw out the debenture. You’ll just have to wait for the courts to give you what crumbs can be spared.